With the summer of 2013 now well behind us, harvests are in full swing through much of the United States. Farmers are busy filling their barns with the bounty of a hard summer’s work.
For investors, however, it’s a different story. Many traders who have picked up a newspaper in the past 12 months are weary of playing the “will they/won’t they” game with the Federal Reserve. Every time Bernanke blinks, the stock market jolts one way or the other. We’ve seen a fascinating bull run in stocks and yet investors still don’t trust it. We really want to accept it, but for some of us, it just doesn’t feel quite right.
Instead, you can leave the whims of the Fed behind and focus on a market whose price direction has less to do with unknown policy changes and more to do with core supply/demand fundamentals and seasonal cycles. The basic agricultural markets offer these qualities.
And none is more basic or more interesting right now than corn. For traders looking to harvest some bounty of their own this fall, they can consider a simple strategy that can profit without taking wild risks, having perfect timing or even picking outright price direction.
Before you can understand how to make money in the corn market, you must first understand the supply/demand factors driving corn prices. These fundamentals are paramount in establishing the long-term price direction of any commodity.
The 2013 season has been a banner year for corn production in the United States. By late July, the U.S. Department of Agriculture was projecting the United States would produce 13.95 billion bushels of corn this year — the most ever.
It is true that corn farmers have increased corn acreage in response to record demand. However, available supplies are likely to outpace demand by a wide margin in the 2013-14 crop year. Ending stocks for next year are pegged at a whopping 1.959 billion bushels. This is almost double 2012 ending stocks and eclipsing this year’s projected ending stocks by nearly 150% (see “Leftovers,” below). Ending stocks represent the amount of the commodity left over in a given crop year (usually September) after all demand has been met. This number can cast a wide shadow over price direction throughout the year.
The reasons for this increased corn production are many. At $5 to $7 per bushel, corn is a profitable choice for farmers. As global demand gradually has pushed higher over the past several years, so have corn prices. Farmers respond by growing more corn to take advantage of the higher price brought on by demand.
The agricultural industry has more than held its own in meeting rising global demand for grains, corn in particular. The genetically modified seed industry has produced higher-yielding, and pest- and drought-resistant crops. Along with better irrigation and farming skills, this has resulted in not only higher yields but a larger growing region for corn. This is why corn is now seen growing in the former wheat fields of the Midwest and former cotton and peanut fields of the South.
Corn acreage accounted for 25% of U.S. fields in 2000. This year it was 30%. More impressive, however, is the growth in yield. In the early 1980s, an acre of corn could be expected to yield about 102 bushels per growing season. In 2013, that figure is 157 bushels.
Weather is always a possible concern, but while hot temperatures and low moisture hampered conditions in 2012, this year has been much more favorable.
Before you go running out to short corn, hold on. The analysis described here is provided to give perspective; it is no secret to the market. Prices held at elevated levels through much of the spring while the 2013 crop was planted. However, as it became apparent that weather was favorable and the crop was developing nicely, prices fell. Corn prices tumbled more than 15% from the highs in late June through the corn pollination period in July (see “Corn slide,” below).
While there still may be opportunities for traders to short corn on rallies this fall, the greater opportunity may be to do the opposite of the crowd and position for a harvest low. Here is why.
In commodities — agricultural commodities in particular — we have a tool that other markets don’t enjoy: Seasonal tendencies. While not perfect, seasonal analysis can help to illustrate certain supply/demand fundamentals that tend to take place at different times of the year.
In corn, the U.S. harvest comes in the fall, sometimes starting as early as late August and finishing in late October/early November. Prices tend to peak when supplies are lowest and bottom when supplies are highest. Thus, at harvest time, when supplies are higher than they will be at any time all year, economics dictates that prices should be at their lowest.
While seasonal charts are an admittedly blunt instrument, the chart for corn seems to bear out this economic phenomenon (see “Seasonal trends,” below). While this chart is only an average of the past 15 years, it does seem to reveal a tendency for corn prices to bottom in early October. That this happens to be right in the heart of the corn harvest is no coincidence.
Thus, we have the term “harvest low” used by ag futures traders around the globe. Once a harvest low is achieved, prices often begin to increase gradually as demand begins to eat away at new supplies.
Encouraging for traders who follow seasonals, corn appears to be correlating well to seasonal averages in 2013. While there obviously is no guarantee that prices will follow the seasonal average, there may be an opportunity for investors to consider during corn harvest time 2013.
Picking a low in any market can be quite profitable for a trader who times it right. Unfortunately, it is also difficult. The road to riches from picking lows in bear markets is littered with the financial corpses of those who got their timing off by even a hair. It’s nearly impossible in futures unless you have deep pockets and nerves of steel. There is a better way to play this without assuming the risk of an outright futures position, however.
In most cases, buying options is a sucker bet. Too many new traders get lured into it as a low-risk way to play the futures markets. (“Your losses are fixed!”) However, buying options has a low success rate. The odds are high that long runs of small losing trades eventually will empty your trading account.
A better route is selling options. Yes, you take on more risk than buying, and the profit potential is limited. But by selling an option, you put the odds of success in your favor. And the risk can be managed. You just have to do it yourself.
Here is how it works. If trading a harvest low in corn, you would begin looking at put options in October for the corn market. How close or far away your strike is from the actual price of corn is dependent on your risk tolerance. The object is to pick a price level that corn will not reach and sell a put option at that strike price for a specified premium. If the option expires with the value of corn anywhere above that strike price, your option expires worthless and you keep the premium as your profit.
The downside to this strategy is that if you’re wrong and corn prices tank, the value of your option will increase. You might have to buy it back at a loss, depending on how much you are willing to lose. Decide how much you are willing to risk prior to entering the trade. If the option increases to that value, buy it back.
The upside is that you do not have to pick the low in corn to be profitable. You can be way off in your pricing or timing and still make money on your trade. If you sell a put option 50 cents below the market, corn can keep falling and you can still hold your option. All corn has to do is be anywhere above your strike at expiration and you win. The high odds and forgiving nature of short options is what attracts many sophisticated investors to the strategy, as long as they are comfortable managing their own risk.
The USDA projects average on-farm corn prices to be from $4.40 to $5.20 for the 2013-14 crop. As a trader, looking to sell puts on the March contract below that range seems to be a high-odds proposition. Sell further away if you seek less risk, closer if you seek higher premium.
Experience shows that premiums in the $400-$500 range work well for corn. You likely will have to go out to the March contract to get them. That’s OK. As an option seller, time is always on your side.
Michael Gross is co-author of McGraw Hill’s “The Complete Guide to Option Selling.” Email him at firstname.lastname@example.org.